This article is an excerpt from Charitable Gifts of Noncash Assets, a comprehensive guide to illiquid giving by Bryan Clontz, ed. Ryan Raffin. Published by the American College of Financial Services for the Chartered Advisor in Philanthropy Program (CAP), with generous funding from Leon L. Levy. For a free digital copy, click here, and to order a bound copy from Amazon, click here.

“Black and Blue”

Generally, anything with a catchy name, acronym, or more than four boxes on a flow chart is a recipe for potential trouble. Insurance and charities have had a very turbulent relationship over the years. In the late 1980s and early 1990s, it was vanishing pre- mium universal life insurance. But the premiums did not vanish, as interest crediting rates dropped, literally tens of millions of dollars of life insurance were lost and non- profits and their donors were furious. Then came charitable split-dollar life insurance in the late 1990s. This is where a donor made a donation, took a deduction and then the charity-owned policy provided a portion of the death benefit into a family trust or to heirs. In 1998, Congress passed legislation outlawing the structure. This led to more upset charities and donors. Then came LILAC (Life Insurance Life Annuity Contracts), which involved very large donor groups and combined life insurance and annuity contracts. Here is a brief overview of the more popular charitable insurance programs in the last decade.

1. Premium Financing—This strategy had the charity borrowing money from a third-party lender at a rate lower than the projections indicated the policy would earn—in essence, interest rate arbitrage. The lender took a collateral interest in the policy for both the death benefit and cash value, and the charity got whatever was left over. This was “free” insurance, since the charity did not have to put any money into the contract and just needed to find a donor(s) where they had an insurable interest. Planners should note that there are nearly a dozen permutations of these structures and every one is a bit different in design.

Nugget #9: This financing was very popular in the early 2000s and more than a few charities participated (see the T. Boone Pickens Plan at Okla- homa State—Athletics Dept. Lawsuit).6 However, illustrations are simply projections based on assumptions which are all but certain to be wrong. Interestingly, most experts thought the plans would buckle if short-term rates ever spiked quicker than the policy crediting rate—the so-called, inverted short-term yield curve. Instead, the plans actually started sinking in 2008 when banks started calling in loans and lines of credit. The policies had not existed long enough to build up enough equity, and while everyone assumed there would be another bank to refinance the notes, very few were successful. And those that were, had to pay the price in higher interest rates, new expenses, commissions, etc.

2. Dead Pools—The idea was that if a charity could get a large enough amount of donor lives, usually 1,000 or more, they purchase a blanket group policy because they had an insurable interest. Note this is exactly the same structure corporations used until the Pension Protection Act of 2006 significantly curtailed it. In some cases, the employees did not even know their employers had insured them (so called “dead peasants” or “janitors insurance”).7 The companies would borrow the money for the premiums, collect death benefits tax free, grow the cash value on their balance sheets tax free, and then deduct the borrowing cost interest.

Nugget #10: If anyone approaches a charity because they need an inter- mediary with an insurable interest, to, as Steve Leimberg says “rent / lease the donors” in exchange for a small projected variable sum, the charity should proceed with caution.

3. CHOLI, FOLI, IOLI and STOLI—These plans, CHOLI (Charitable Owned Life Insurance), FOLI (Foundation Owned Life Insurance), STOLI (Stranger Owned Life Insurance), and IOLI (Investor Owned Life Insurance) all share the same general structure. The charity was to select a few very high net worth donors who would allow the charity to take out an insurance policy on their lives. The charity could provide the premium payments, though usually it was premium financed (see above), and then the idea was to sell the policy to another person (usually STOLI) or as a securitized block of lives (usually IOLI).

Nugget #11: Again, this model was a “rent our donor base”-approach but insurance owners here usually focused on a few select lives. Promoters sold it as free insurance for the charity, and as an added enticement, the insured donor was usually able to direct five percent or so of the death benefit to the charity. Many donors did not realize that the policies were usually quite large and therefore used up much of their insurance capacity.

That means that if the person had $20 million in assets, she might be able to get $20 million or so of insurance. But if Alma Mater U took out a $20 million policy on her, and then she later realized she had a need for additional insurance, insurers may decline her due to limited additional capacity. Carriers may deem her to be “over-insured” even though she was not receiving any direct benefit from the charitable policy.

Perhaps there may be some scenario where these kinds of plans may work. However, when many in the insurance industry believe these strategies have no business purpose, can harm the companies themselves, and are bad policy, planners should think twice about these programs.

It’s Up To You

Most gift planners tend to be in either the “insurance is bad” or “insurance is good” camp. The last two sections attempted to draw a bit of a line between good and bad, perhaps fairly or unfairly. This section will outline strategies which are a bit more ambiguous.

1. Life Settlement—This is where a charity sells an insurance policy in the secondary market. As mentioned, the intent of selling the policy when it is originally issued can create a number of problems. Usually this is done after two years to clear the incontestability clause. But from time to time, charities may receive large policies from donors who do not wish to con- tinue paying premiums, or charities may have owned a policy for a long time and now the donor cannot pay the premiums.

Charities should understand the process of settlement. First, the policy must qualify—usually that means an insured donor at least 70 years old, owns a $1 million policy and has a life expectancy between 2–10 years. Ideally (for the settlement process), the donor has had a severe decline in health after the insurer issued the policy. Second, the insured must agree to release all records to a third-party broker or directly to an institutional buyer. Third, the buyers calculate their bids from the cash value, donor’s age/health, death benefit, type of policy, quality of company, minimum required premiums, etc. Before the 2008 economic downturn, these bids were usually calculated at a 10 to 14 percent internal rate of return.8 Of course, one policy could deviate significantly from that rate which is why investors securitized/bundled many of these policies into the financial markets. After 2008, much of the funding has dried up and now investors are looking for rates between 16–20 percent in some cases. Still, estimates are that donors sell approximately $2 billion of life insurance death benefit annually into the secondary market.

Nugget #12: If the donor can no longer make premium payments, and the facts / policy meets the conditions, should the charity just keep the policy and pay it with other funds? Rather than giving the investor 10–20 percent, it would seem prudent to retain that asset.

But some charities have a policy against fronting the money for premiums, or do not want the risk of a single policy, or do not want the hassle of on-going administration, or the donor may want to see the charity use the money while she is still alive. Hence, selling the policy in the secondary market may make sense.

2. Life/Annuity Underwriting Arbitrage—This strategy has been around since the late 1990s. The idea is that the charity takes a high-net-worth donor, usually between 70–85 years old, and who has some nonmajor health issue (i.e., prostate cancer in remission from ten years ago, managed diabetes, etc.). Then, it asks 15 or so life insurance carriers to bid on a $5 million life insurance policy. The charity then asks the same carriers to bid on a $5 million immediate annuity that is medically underwritten (these policies have higher payouts based on a shorter life expectancy). Interest- ingly, the life underwriting might show anywhere from a 10 to 20 year life expectancy since different companies have different experience with var- ious maladies, as does immediate annuity underwriting. Then, the charity picks the life insurance company that has the longest life expectancy, and the immediate annuity carrier with the shortest life expectancy—hence the hedged spread.

The hypothetical math would work like this:

$5 million in premium for the immediate annuity Annual payout of $700,000

$5 million life insurance policy Annual premium of $400,000

Net Annual Cash Flow $300,000

Net Lifetime Guaranteed Rate of Return is six percent ( $300,000 / $5,000,000). When the donor dies, the immediate annuity stops, but the life insurance pays off the full $5 million—the entire original principal.

Nugget #13: If designed correctly, the return can provide close to a risk- free bond equivalent return. Charities have used it for an endowment fixed alternative, in CRATs and in CLATs. Hence there are a number of interesting applications, but the entire solution relies on getting enough of an under- writing spread between two different insurance carriers to achieve a fixed rate of return worthy of the effort.

3. Life Insurance in CRTs—There are a number of private letter rulings that allow a CRT to own a life insurance policy. The charity/trustee can fund these with either existing policies or can issue new ones. The primary reason this is done is to provide a spike in income to the surviving income beneficiary after the first death.

And a more recent ruling has allowed a CRAT to purchase an immediate annuity.9 This could have a number of uses for CRATs, in particular, where they wish to transfer the longevity and investment risk for a portion of the assets, while still making the guaranteed payout (in essence, reinsuring the liability).

Nugget #14: Using life insurance inside of a CRT is a challenging proposition in terms of administration, valuation, etc. But these issues are not insurmountable if it provides a specific solution for the client. Still, it is a rare planning technique.

The recent Private Letter Ruling for immediate annuities inside of CRATs could open up better income planning in that area. Given the recent decade’s investment performance, many CRATs are underwater already, and some have already exhausted or are projected to exhaust. This will provide a tool for donors / trustees who need a guaranteed income stream to minimize the probability of exhaustion.

4. Annuity Donations—Both fixed and variable annuities may be donated to charities. But as an ordinary income asset (like life insurance), regulations limit the deduction to the lesser of fair market value or adjusted cost basis. However, unlike life insurance, any embedded gain inside the policy is accelerated at the time of the assignment or transfer. So practically speaking, while doable, it usually does not make much sense. It is usually best to simply surrender the policy for cash, and then contribute the net proceeds as a cash contribution (or alternatively, a long-term appreciated capital asset).

Nugget #15: If the donor gives the annuity policy to charity prior to sur- render, it still must have a qualified appraisal to substantiate the deduction if the value is greater than $5,000.

5. Life Insurance as an Investment/Asset Class—In recent years, some insurance thought-leaders have challenged people to reconsider how they view life insurance. Not only does permanent insurance provide risk management protection, it also provides guaranteed growth in cash values and a death benefit. Life insurance, in many ways, is a vastly under-appreciated asset. It grows income tax-free. The death benefits are usually income tax-free, and owners can easily remove it from their estates using an Irrevocable Life Insurance Trust.

Further, while a tax-free four to six percent rate of return to life expectancy used to seem paltry in the late 1990s, the more recent market environment has shown the benefits of a slow but steady return. So for many people who need life insurance protection for various reasons, re-calibrating their thinking to include permanent policies as a fixed income asset class alternative is reasonable. Yet, the challenge lies with the application of this concept to charities. Nonprofits are already tax-free, so the three key insurance benefits are immediately lost. Most are not dependent on any specific donor who needs life insurance. So the question is, barring early death (which no one can predict), are there better fixed income investment alternatives? And since life insurance companies are investing nearly all of their general account assets in institutional bonds, charities can access these same markets through institutional money managers.